HSBC: This is what a doom loop looks like in China

A
police officer from the SWAT team seen at an anti-terrorism drill
in Weng'an county, Guizhou province, in 2012.REUTERS/China Daily

HSBC, one of the few optimists on China's prospects, has
identified a vicious circle that could hit the country's economy
in the years to come.

Qu Hongbin, the bank's chief economist for China, cut his growth
forecast for 2016 and 2017 to 6.7% from 7.2%.

That's still higher than a lot of banks' estimates, but the HSBC
analyst report struck a gloomy tone.

It focuses on how slowing demand leads to falling inflation,
which in turn hurts demand even more as people and companies hold
off on purchases while prices are falling.

Here's HSBC (emphasis ours):

We expect that the slowdown in demand will be faster than the
slowdown in the supply potential of the economy, resulting in
a persistent negative output gap.

In simple terms, China will keep producing a lot of things but
fewer people will buy them, meaning prices will keep dropping and
deflation will accelerate.

And this is the result:

As we have argued repeatedly this year, deeper deflation could
have a negative impact on expectations and growth which
may become a self-fulfilling prophecy. It also led to an
increase in leverage. In order to break the circle of
self-fulfilling expectations, policy makers need to act more
aggressively, in a co-ordinated manner.

This is the crux of the vicious circle that Chinese policymakers
will do anything to avoid.

Deflation is bad for all economies, but in China, which has high
levels of corporate debt, it can spell disaster because it makes
fixed interest-rate payments more expensive.

And corporate debt in China has grown faster than in any
other top-15 economy.

Here's the chart:

BAML

As UBS pointed out last week, the cost to companies in
emerging markets to service their debt, or make payments on
interest and principal, has increased dramatically.

Chinese businesses need inflation and demand to both take the
sting out of debt repayments and boost profits.

But with oil keeping costs and prices low, and the US Federal
Reserve preparing its first interest-rate rise since the 2008
financial crisis, immense pressure is now on China's government
and central bank to do something big to stimulate the economy.